Prediction Validated? China and the Dollar

Last year, W. Patrick Lang and Larry C. Johnson ("Contemplating the Ifs", Spring 2006)  urged U.S. policymakers to consider the consequences of China's diversification of its foreign currency reserves.  Now that China seems to be getting rid of it

Last year, in laying out various scenarios for how the United States might choose to confront Iran's pursuit of a nuclear weapons program ("Contemplating the Ifs", The National Interest, Spring 2006), W. Patrick Lang and Larry C. Johnson noted that U.S. planners have to consider factors far beyond developments in the Persian Gulf.

One point they raised:

[China] hold[s] a substantial amount of U.S. debt. What happens if they decide to find some other currency to hold instead of the dollar? . . . Although the dollar traditionally has been the currency people seek during a crisis, the growing imbalance with China creates new dynamics that could convince the Chinese that holding dollars no longer made economic sense. Under such a scenario, dumping dollars on the international market would trigger an inflationary spiral in the United States.
The scenario of an inflationary spike triggered by China's dumping of dollars may strike some as fanciful. The point for U.S. planners and policymakers, though, is to recognize that war brings unintended consequences that go well beyond the tactical realities on the ground where the fighting occurs.

In other words, the United States needs to consider what happens if China uses its financial leverage to affect U.S. freedom of action.

The Daily Telegraph is now reporting:

A sharp drop in foreign holdings of US Treasury bonds over the last five weeks has raised concerns that China is quietly withdrawing its funds from the United States, leaving the dollar increasingly vulnerable. . . .
David Powell, an economist at IDEAglobal in New York, pointed the finger at Beijing as the main suspect in the sudden bond flight this summer.
In a client note entitled "Has China started to dump US Treasuries?", he said the sales appear to coincide with early moves by Beijing to launch its new $300bn sovereign wealth fund.
The scheme is part of the government's plan to diversify it $1,340bn reserves from bonds (mostly in the US) to a broader portfolio of investments and a better yield.

This follows an announcement last month in Beijing that the government was considering shifting some of its assets out of U.S. Treasuries:

Two officials at leading Communist Party bodies have given interviews in recent days warning-for the first time-that Beijing may use its $1.33 trillion (£658bn) of foreign reserves as a political weapon to counter pressure from the US Congress.
Shifts in Chinese policy are often announced through key think tanks and academies.
Described as China's "nuclear option" in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.
It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.
Xia Bin, finance chief at the Development Research Centre (which has cabinet rank), kicked off what now appears to be government policy with a comment last week that Beijing's foreign reserves should be used as a "bargaining chip" in talks with the US.

Perhaps it is not going to transpire-this time. Perhaps this is just a warning shot across the bow. But it also seems that some in Beijing are considering points that Vladimir Averchev raised at The Nixon Center earlier this month, when he rhetorically asked what the incentive was for Russia to purchase more dollars and U.S. Treasury bonds. It seems some in Beijing are asking the same question.